Assignment of Rights in Lawsuit Results in Capital Gain

The Eleventh Circuit held that a
taxpayer's assignment of his rights in an ongoing lawsuit over
a land sales contract was the sale of a right to purchase the
land subject to the contract, not the sale of the land, and
resulted in long-term capital gains to the taxpayer.

Background

From 1994 to 2006, Philip Long,
as sole proprietor, owned and operated Las Olas Tower Co. Inc.
(LOTC), which was created to design and build a luxury
high-rise condominium called the Las Olas Tower on property
owned by the Las Olas Riverside Hotel (LORH). LOTC never filed
any corporate income tax returns and did not have a valid
employer identification number. Instead, Long reported LOTC's
income on the Schedule C, Profit or
Loss From Business (Sole Proprietorship), of his
individual tax return.

In 2002, Long, on behalf of
LOTC, entered into an agreement with LORH (the Riverside
agreement) whereby LOTC agreed to buy land owned by LORH for
$8,282,800, with a set closing date of Dec. 31, 2004. LORH
subsequently terminated the contract unilaterally and, in
2004, LOTC filed suit in Florida state court against LORH for
specific performance of the contract and other damages. LOTC
won at trial, and the court ordered LORH to sell the land to
LOTC pursuant to the Riverside agreement. LORH appealed the
judgment. In 2006, Long entered into an agreement with Louis
Ferris Jr. (the assignment agreement), under which Long sold
his position as plaintiff in the Riverside agreement lawsuit
to Ferris for $5.75 million.

On his 2006 tax return
filed in ­October 2007, Long reported the income from the
assignment agreement as capital gains. In September 2010, the
IRS issued a notice of deficiency for 2006 to Long, claiming
among other things, that the income from the assignment
agreement was ordinary income, not capital gains. Long
challenged the IRS's determination in Tax Court.

In
Tax Court, the IRS argued that Long received the $5.75 million
in lieu of future ordinary income payments and, therefore,
that money should be counted as ordinary income under the
"substitution for ordinary income doctrine." The Tax
Court, treating the assignment agreement as a sale of the land
under the Riverside agreement, found that Long intended to
sell the land to a developer and concluded that the
applicability of the capital gains statute depended on whether
Long intended to sell the land to customers in the ordinary
course of his business. The Tax Court determined that, while
Long intended to sell only the land for the Las Olas Tower
project, and not the individual condominium units themselves,
the $5.75 million payment for Long's position in the lawsuit
nevertheless constituted ordinary income because Long intended
to sell the land to customers in the ordinary course of his
business. Long appealed the Tax Court's decision to the
Eleventh Circuit.

In the Eleventh Circuit, Long argued
that the $5.75 million he received from the assignment
agreement should be taxed as long-term capital gain rather
than as ordinary income. Long contended that he only had an
option to purchase LORH's land and the only asset he ever had
in the Las Olas Tower project was the Riverside agreement.
Therefore, the asset he had sold was the right to purchase
land, not the land itself, and the sale was the sale of a
capital asset and resulted in capital gains income.

In
response, the IRS again argued that Long's proceeds from the
assignment agreement were not capital gains from the sale of
an asset, but rather a lump-sum substitution for the future
ordinary income Long would have earned from developing the Las
Olas Tower project. Thus, under the
substitute-for-ordinary-income doctrine, the $5.75 million
lump-sum payment was taxable as ordinary income. Additionally,
in light of this analysis, the IRS argued that the Tax Court's
discussion of factors to determine Long's primary purpose for
holding the property was irrelevant. Alternatively, the IRS
argued that the assignment agreement was a sale of Long's
judgment, which resulted in short-term capital gain because
Long sold the judgment less than a year after it was entered
by the Florida court.

The Eleventh
Circuit's Decision

The Eleventh Circuit reversed the
Tax Court and held that the income from the assignment
agreement was capital gains rather than ordinary income. The
Eleventh Circuit found that the Tax Court had erred by
misconstruing what property Long had sold, and it rejected the
IRS's arguments that the income was short-term capital gains
or that the substitute-for-ordinary-income doctrine
applied.

The Tax Court analyzed the capital gains issue
as if the land subject to the Riverside agreement was the
property that Long disposed of in return for $5.75 million.
The Eleventh Circuit, however, found that the record from the
Tax Court made clear that Long never actually owned the land,
and, instead, sold a judgment giving the exclusive right to
purchase LORH's land pursuant to the terms of the Riverside
agreement. In other words, Long did not sell the land itself,
but rather his right to purchase the land, which was a
distinct contractual right that might be a capital asset.

The court explained that this distinction was material
because the "property" subject to the capital gains
analysis was really Long's exclusive right to purchase the
property pursuant to the court judgment. Therefore, the
correct inquiry was not whether Long intended to sell the land
to customers in the ordinary course of his business but
whether Long held the exclusive right to purchase the property
primarily for sale to customers in the ordinary course of his
trade or business. The court found that there was no evidence
that Long entered into the Riverside agreement with the intent
to assign his contractual rights in the ordinary course of
business, nor was there evidence that, in the ordinary course
of his business, Long obtained the court judgment for the
purpose of assigning his position as plaintiff to a third
party. Rather, the record indicated that Long always intended
to fulfill the terms of the ­Riverside agreement and develop
the Las Olas Tower project himself.

The court concluded
that the IRS's short-term capital gains argument failed
because the IRS was using the wrong date as the acquisition
date for the asset that was subject to capital gains
treatment. Because the court found that the asset was Long's
exclusive right to purchase land, he obtained the asset in
2002 when he executed the Riverside agreement, which was well
over one year before he sold the asset in 2006.

With
respect to the substitute-for-ordinary-income doctrine, the
Eleventh Circuit observed that whether the doctrine applied
depended on the type and nature of the underlying right or
property assigned or transferred. If a lump-sum payment is for
a fixed amount of future earned income, it is taxed as
ordinary income. In Long's case, the court concluded that the
profit he received from selling the right to attempt to finish
developing a large residential project that was far from
complete was not a substitute for what he would have received
had he completed the project himself. According to the court,
Long's profit was not simply the amount he would have received
eventually, discounted to present value. Rather, his rights in
the LORH property represented the potential to earn income in
the future and, under Eleventh Circuit precedent, selling a
right to earn future undetermined income, as opposed to
selling a right to earned income, is a critical feature of a
capital asset. Thus, the court concluded, the fact that the
income earned from developing the project would otherwise be
considered ordinary income was immaterial.

Reflections

While the Eleventh Circuit
correctly determined that the assignment agreement was not
equivalent to a sale of the land subject to the Riverside
agreement, it could be argued that it incorrectly determined
that the assignment agreement was a sale of a right to
purchase the land. At the time of the assignment, LORH's
appeal of the trial court's decision in the litigation over
the Riverside agreement was ongoing, and Ferris received
Long's rights as plaintiff in that litigation. Given that the
litigation was ongoing when the assignment agreement was
executed, Long did not yet have a choate right to purchase the
land. However, even if the court had found that Long had
assigned his rights as a plaintiff, whatever those ultimately
ended up being, presumably it would have still held that Long
had long-term capital gains from the assignment.

The winners of The Tax Adviser’s 2016 Best Article Award are Edward Schnee, CPA, Ph.D., and W. Eugene Seago, J.D., Ph.D., for their article, “Taxation of Worthless and Abandoned Partnership Interests.”

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